Inflation targeting: What’s the point?

Following the Reserve Bank’s Monetary PolicyStatement earlier this month, some economists are questioning the need for theBank to maintain a strict inflation target. Some have gone so far as to saythat inflation targeting has failed to improve New Zealand’s economic wellbeingand should be done away with altogether.

Such attitudes are scary – inflationtargeting by a credible central bank is a vital part of sound economicmanagement.

Inflation is costly for a number ofreasons: it reduces the purchasing power of those on fixed incomes, punishessavers, increases the volatility of prices, and forces firms to constantly updatetheir price schedules. All of these consequences represent a waste ofresources and effort which lower our wealth and welfare.

However, the main cost of high inflationrelates to the inability of some prices to move when others do. The mainpurpose of a price is to illustrate the value of one product or service relativeto another. Inflation reduces the clarity of those price signals and leads to aninefficient allocation of resources, reducing national wealth.

Even if we accept that inflation isinherently bad for the economy, some people may still question whether using aninflation target is an effective way of controlling inflation. Setting anexplicit inflation target provides a clear signal of where inflation is likelyto head over the medium term. From time to time, prices for some individualgoods and services will rise more quickly or slowly due to specific economicfactors (petrol and food prices are current examples). But if people believethe Reserve Bank’s commitment to fighting inflation is credible, then they willexpect such price "shocks" to be only transitory. Sometimes headline inflationwill be above the target, and sometimes below, but a credible central bank willgenerally maintain average inflation close to its target over the medium term.

Inflation, and inflation expectations, havea self-fulfilling element that comes in at this point. If people believe averageprices are only going to rise in line with the Reserve Bank’s target rate then,in the absence of specific shocks to their business, they will set their prices(and wages) in a way that is consistent with this belief. This behaviour helpsto keep overall inflation low without having to bump up interest rates and slowdown the economy.

Recent economic events (drought and higherpetrol prices) have raised questions about the Reserve Bank’s flexibility torespond to shocks to the productive side of the economy, given the currentinflation targeting regime. Cutting interest rates now seems out of step withthe inflation pressures coming from higher food and petrol prices. But if pricesetters believed that the Bank was credible in fighting inflation, average priceand wage setting behaviour would continue in a manner consistent with theBank’s explicit inflation target. The shocks would eventually be workedthrough and inflation would return towards its target.

The underlying confidence that inflation is"anchored" would in fact allow the Bank to reduce interest rates and helpprevent a more pronounced slowdown in economic activity. In other words, the combinationof an inflation target and the Bank’s reputation as an inflation fighter shouldgive them the room to cut interest rates in the face of shocks to theproductive side of our economy.

The problem that the Reserve Bank faces incutting interest rates this year is that its inflation-fighting credibility isunder a cloud. Although the Bank has said that it believes "inflationexpectations remain anchored", our graph suggests otherwise. Adjustments tothe policy targets agreement in 1999 and 2002, statements by Dr Cullensuggesting that monetary policy may need to change, and policy decisions fromthe Reserve Bank that have allowed domestic inflationary pressures toconsistently build over the last five years have damaged this credibility andled to higher inflation expectations.

Inflation expectations are now closer tothe top of the Bank’s 1-3%pa target band than the middle, implying that wageand price-setting will be conducted in a way that is consistent with higherinflation expectations. Once again the element of self-fulfilment arises, ultimatelyleading to inflation being sustained at higher levels.

If the Bank decides to rapidly cut interestrates now in order to boost consumer sentiment, the medium-term results will beeven greater levels of inflation, higher inflation expectations, and a farcostlier re-adjustment period if the Bank wants to get inflation back downagain in the future.

So although drought and other externalshocks mean that economic growth will be weak over the next 12 months, insteadof laying the blame on the Bank’s inflation targeting regime, we should becriticising the policy changes that have gradually eroded the Bank’scredibility and are now preventing the achievement of this mandate.

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